This is the relationship that Schweser gives: Unbiased forward rate relationship: expected 1 − year spot rate = 1 − year forward rate Can it ever be the case that Expected rate = forward rate? I am finding that part a little hard to get. Tks
And also, I am having a major headache getting the foreign exchange part. More specifically, the way things have to be denominated FC/DC, DC/FC. Is there some kind if ready reckoner for this stuff?
sparty419 Wrote: ------------------------------------------------------- > This is the relationship that Schweser gives: > > Unbiased forward rate relationship: expected 1 > − year spot rate = 1 − year forward > rate > > Can it ever be the case that Expected rate = > forward rate? I am finding that part a little hard > to get. > > Tks The theory of Futures prices as being unbiased predictors of expected spot prices is exactly that… E(So) = F(o). Unfortunately, in real life, this doesn’t seem to be the case (don’t know why though). If you think about it in terms of the forward pricing equation, the concept of a risk-adjusted forward rate doesn’t exist. That is, we only ever use the risk free rate plus/minus any adjustments for carry costs or yield (such as dividends in the case of equity forwards). Hope this helps clarify.
are we talking backwardation and contango here?
Nope. The first problem with the unbiased thing is Siegel’s paradox. The forward rate can’t be unbiased for the future spot rate because you can’t have E(F) = S and E(1/F) = 1/S because of Jensen’s inequality from math and the bias can’t depend on how the rate is quoted. So much for the mathematical sense of unbiased. However, Siegel’s paradox is overall a small player in currency bias. There are about 50,000 academic papers written about this and most point out that there are significant covariates, cointegration with all kinds of things and flat out main effects of interest rates. Hard to make money trading most of those though.
I don’t quite get your meaning Joey. E(F) <> E(S), so where did you get E(F) = S? dinesh… I believe that both backwardation and contango are cases where E(So) <> F(o).
Oops that’s because I made a typo - I meant F=E(S)
CFAI materials say that a statement that futures prices are unbiased predictors is questionable. They talk about it in the reading about pricing futures (SS 16). According to the materials futures price is typically below the expected spot price.
Hmm…Depends on how it is quoted?
true, they are talking about equities and commodities
Hmm…Maybe but those are very different So equity futures are certainly arbed by the machine so saying that the equity futures price is below the expected spot price is a lot like saying you expect equities to increase at better than the risk-free rate (not quite but really close). That commodity futures have futures prices lower than expected spot prices is because of normal backwardation (which, I suppose, is about the same reason that equity futures are priced lower than expected spot because equity holders get compensated for risk so maybe it’s not that different).
My understanding of backwardation in the commodities market is due to the fact that the commodity, esp those used in productive processes, has value to the holder as it can be used in the productive process, whereas this does not apply to financial assets like equities. Maybe I’ve got my understanding wrong about this… it is after all a Monday.
The reason why Equities Futures Contracts are valued at a Future Price which is less than the Expected Spot price may be due to the dividend paying feature of those stocks. So it would be valuable to hold a stock and get those additional tit-bits of income than to hold a future on the stock. But on the other way round, if we are having a corn futures contract where holding the underlier (corn) is a painful job (due to preservation/maintenance of the corn) then the Future Price is more than the expected Spot price
dinesh.sundrani Wrote: ------------------------------------------------------- > The reason why Equities Futures Contracts are > valued at a Future Price which is less than the > Expected Spot price may be due to the dividend > paying feature of those stocks. > Nah, dividend is essentially known so it is included in both the futures price and the expected spot price. > So it would be valuable to hold a stock and get > those additional tit-bits of income than to hold a > future on the stock. But on the other way round, > if we are having a corn futures contract where > holding the underlier (corn) is a painful job (due > to preservation/maintenance of the corn) then the > Future Price is more than the expected Spot price Ah, but not always. You and darkhelmet will get to discuss all this a lot more next year on LIII.
I knew about the dividend bit. I was referring to the functional use of the underlying commodity in the production process, which makes it more valuable today than it does in the future. For instance, you can’t put a futures contract to break down crude oil in to gas products so if you (a major oil refinery, for instance) are facing a short term supply crunch due to (pick one… fire, war, terrorism, stupid Bush policies, etc.) you would of course value having the oil on hand as opposed to having a future stake in oil. I believe this is why we see normal backwardation in many commodity businesses. As such, this is in fact a structural facet of the underlying business, which manifests itself in normal backwardation. After looking up Siegel’s paradox, I understand your meaning a bit more and I can kind of see how Jensen’s inequality steps in here by describing the relationship b/w Spot and Forward as a convex function (I think). Well… so much for theory.
JoeyDVivre Wrote: ------------------------------------------------------- > dinesh.sundrani Wrote: > -------------------------------------------------- > ----- > You and darkhelmet will get to discuss all this a lot more next year on LIII. I hope I pass the exam this June-08 itself, else waiting for 1 more year would be atrociously brutal.
You will. So will darkhelmet.
Thanks for the vote of confidence… 66 days left to go and self-doubt is creeping up my leg.